The 500 K salary cap

Obama Calls for 'Common Sense' on Executive Pay:

resident Obama announced on Wednesday a salary cap of $500,000 for top executives at companies that receive the largest amounts of money under the $700 billion federal bailout, calling the step an expression not only of fairness but of "basic common sense." The restrictions, however, allow an exception for restricted stock.

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"That is pretty draconian -- $500,000 is not a lot of money, particularly if there is no bonus," said James F. Reda, founder and managing director of James F. Reda & Associates, a compensation consulting firm. "And you know these companies that are in trouble are not going to pay much of an annual dividend."

Mr. Reda said only a handful of big companies pay chief executives and other senior executives $500,000 or less in total compensation. He said such limits would make it hard for the companies to recruit and keep executives, most of whom could earn more money at other firms.

"It would be really tough to get people to staff" companies that are forced to impose these limits, he said. "I don't think this will work."

Megan Barnett at Portfolio contends this is a bad idea:

Oppenheimer's Meredith Whitney said it tactfully: "You're going to get a different variety of folks who are going to come in." Translated, with less diplomacy, that means Wall Street is going to be run by executives with subpar experience and drive.

Money, Whitney notes, is what motivates people to come to Wall Street. It's not a public service job, nor should it pay like one.

But perhaps most important, Obama's compensation plan is a great example of misplaced power. The Treasury Department shouldn't be wasting its time and effort on policing the payroll departments at the banks it now partially owns.

If the administration really wants to insert government into the troubled private sector, it should just go whole-hog and nationalize the banks that are teetering on the edge of the abyss.

I think Barnett is right that this is driven more by public relations than genuine fundamental problems with our economic system; executives may make too much money, but it's a fraction of a rounding error on the books of these companies. That said, I agree with Megan McArdle:

Under ordinary circumstances, perhaps. But executives are already leaving these firms in droves, supervised by security guards who carefully watch them clean out their desks. The market for used investment bankers is, as they might say, extremely illiquid.

Under those circumstances, I think this is reasonable. And while I am not particularly offended by the size of investment banking paychecks--though why they persisted in an allegedly competitive market is still something of a mystery to me--I don't think the taxpayer ought to be funding Swiss skiing chalets and Palm Beach Mansions. Get a house in Scarsdale and take the train like everyone else. If they don't like it . . . well, there's precious little evidence that any of them are the sole indispensible genius who can save their firm from the economic crisis, now, is there?

I think Megan hit the nail on the head when she talks about the supposed value-add of $10 million dollar executives. Our banking system is quasi-nationalized, it should be no surprise if the heads of these firms are going to be more in the mode of utility CEOs in the future. There is a lot of talk about zombie companies right now, banks which are insolvent and companies like Chrysler which really have no way of making more money than they lose. There's no way that the best talent is going to save these companies, rather, the best outcome is probably to unwind them in a manner which isn't catastrophic. "10 business rules for retards" is all you really need here, not a fine-grained understanding of financial mathematics. Other firms, such as Wells Fargo, probably have a potential future as profitable businesses, but right now their primary goal is to make it through tough times. Rather than risking-taking geniuses who increase value by being audacious, what companies like Wells need are non-retards who make sure not to put a gun in their mouths and pull the trigger (the fact that banks aren't lending isn't because they're stupid and all the geniuses are gone).

Many people would contend that the "best talent" on Wall Street are very bright people. But, their brilliance was being applied to the task of capturing the maximum economic output for themselves as opposed to creating new efficiencies in the flow and allocation of capital. Consider an individual with a computer engineering degree from State U., and another with a Ph.D. in physics from University of Chicago. If both were hired by Intel, I believe that the likelihood of the second individual generating world-changing innovation is likely on the orders of magnitude greater than that of the first, but the salary difference may only be multiplicative. Now assume that the first individual becomes a community banker, while the second works on Wall Street. The difference in monetary reward might now be on the orders of magnitude (e.g., $1 mill salary + bonus vs. $100 K salary + bonus), but would the genuine value-added economic productivity gained by society due to the Wall Street banker actually be orders of magnitude greater than that of the community banker? As a point of fact many local banks are in good shape because they didn't have the best and the brightest; these relatively pedestrian and dull individuals didn't increased corporate "value" by engaging in risky but high pay-off decisions. Instead of changing the expected value of the increase in growth of a firm, I would suggest that the "best talent" increased the variance of the expected value. During times of plenty the risk translated into very high returns, but now that risk is dragging firms down. In an ideal free market the firms who took risk would go bankrupt. Perhaps there would even be clawback on compensation; after all, why not take massive risks if your upside is not balanced by a negative signed downside? But that's not the world we live in.

Note: Wage & price controls are a bad idea. But like I said, our banking system is nationalized in all but name. Since we've socialized the downside, we need to socialize the upside. Secondly, the decline of retarded financial instruments on Wall Street means less credit for Main Street, and no more mailboxes stuffed with credit card offers. This is not a bad thing, because growth fueled on unending credit isn't real growth at all. I think that in many ways the situations of Americans who engaged in the game of "flipping" is what happened on Wall Street writ small; some people got out in time with their gains, while others did not. Those who did not get out in time now want their own bailout. Those who did get out in time are not going to be asked to return their gains. Here's the key: many flippers weren't retards, they knew they were taking a big risk. Now we're socializing the downside of that risk, those of us who didn't crank up the variance around our expected value are going bailout those who did and got screwed by the game they were playing, while those who lucked out get to pocket their winnings.

Update: See Jim Manzi's post:

The proposed limits on executive pay, if they have any teeth as they are really implemented, are likely to have several knock-on effects. People who are able to make millions per year in a competitive market will tend to drift away from these firms (even though these restrictions only apply to senior executives, they would change the compensation culture for the firm as a whole), and form new asset management firms, M&A advisory boutiques and so on. Along with limits on comp, the government-sponsored entities will have restrictions on investment behavior imposed by the government - they will not be issuing a lot of credit default swaps. This will mean these large institutions will be unable to offer very high rates of return as compared to the firms that don't take government money, but will offer safety.

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Fortunately, the cap excludes options and arrangements that reward long-term performance tied to the government's stake.

Executives that lose as much money as these people need to be fired immediately first and then blacklisted against ever running a public American company again. If they bellyache about how they cannot survive on $500,000. a year then they can go to hell as well. The nonsense about losing so-called talent at top management positions is absurd on its face. If this is the talent then they should have never had the job in the first place. It's going to be many years before the American taxpayer will be able to undo the damage these morons
have brought on the country. In Japan they would commit Hari-Kari and we would be done with them.

By iremember (not verified) on 04 Feb 2009 #permalink

"Consider an individual with a computer engineering degree from State U., and another with a Ph.D. in physics from University of Chicago. If both were hired by Intel, I believe that the likelihood of the second individual generating world-changing innovation is likely on the orders of magnitude greater than that of the first"

I'm sure you would but such hyperbole is quite unjustified. Firstly, because Intel is a mature and increasingly sclerotic company (do we really need ever more massively parallel execution of backwardly 8008 compatible instructions?) and secondly because the vast majority of engineering patents, are indeed generated by just such people from the 2nd (and lower, think of Asian technical schools whose curriculums would not even be accredited here in the US, especially many in India) tiered schools that you so cavalierly dismiss. There are simply not enough spots at the handful of top universities to accomodate all the creative high IQ people.

Intellectual talent is much more evenly dispersed across society (including the banking industry) than are Ivy League, or even University of Chicago, degrees.

BTW FWIW for the keenly status anxious, my onliest ;-) degree is a BA '73 from Cal.

I do favor nationalization, but I don't think that that's the point that people are trying to make. That would entile firing almost everyone with no severance and bringing in new people.

think that the salary cap is mostly PR, but I think that people in finance who think that they'll jump to a better-paying job are fooling themselves. There are fewer jobs and less money in finance than there was a year ago, and I don't think that finance people who are forced to switch by their firm's bankruptcy will be high on the hiring lists. The idea that the people who ran these companies into the ground are geniuses who deserve high pay is clownshow.

I believe, but can't prove, that the supersmart people on Wall Street, quants and Nobelists, may have done more harm than good because of the narrowness of their rationality.

By John Emerson (not verified) on 04 Feb 2009 #permalink

james, don't read too much into my specific example. the details of the distribution aren't too important to me, i was simply arguing that the return-on-value-add results in a much smaller difference in $ in one field than in the other (the main exception is that there are mega-rich tech people like gates, ellison, etc., but within the 100 K to 10 million range i think the assertion might hold, that is, the diff. between medians would be much greater than between means).

Let's think about this logically. We've been paying executives more and more each year, and look what happens HORRENDOUS performance across the board. If your multi-billion dollar company ran itself down to the ground under your watch, you haven't been pulling your weight. Let's keep in mind, that these multi-billion dollar companies were founded and grown by people making vastly smaller sums of money, and they performed just as well if not better.

If your multi-billion dollar company ran itself down to the ground under your watch, you haven't been pulling your weight

not necessarily. many of these CEOs argue that there are exogenous factors which make it almost impossible to succeed by the old metrics. IOW, bad performance isn't due just to their own decisions. but the flip side is that it seems likely when times were good it was due to exogenous factors (rising tide lifts all boats, etc.), so the salaries & bonuses they received because of their genius decisions were not founded in a causal relationship. see fooled by randomness. another way to look at it is this: they're not geniuses, but they aren't retards either. OTOH, since they were paid like geniuses shouldn't they now be paid like retards?

but you're right to point out the differences between what we're talking about here, and people who run smaller firms, or entrepreneurs. many in the latter have a lot of "skin in the game," if their business fails they they lose all the collateral they might have put up to seed their enterprise. that's not just a $0 due to under performance, but an enormous negative consequence for failure.

I believe, but can't prove, that the supersmart people on Wall Street, quants and Nobelists, may have done more harm than good because of the narrowness of their rationality.

many of these people probably made more $$$ per year than they would have in their whole careers in research. if $$$ is the measure of a man, then they done awful good for themselves! they were eminently rational. as long as society doesn't collapse and they weren't overextended in their own consumption habits they come out way ahead.

IOW, they might have done more harm to total output because of all issues like var (ok, way more complicated than var), but they redistributed a nice chunk of change over the years from the retarded rich who didn't think that follow the 10 rules for their kind were sufficient. it isn't like the rich retards are going to be able to clawback most of the fees ;-) i'm less concerned that the rich retards were dazzled by magic derivatives than that many super-geniuses were spending their 20s & 30s moving money as opposed to innovating.* the positive externalities of getting mucho-rich are way less than inventing a new technology which increases total societal productivity.

* yes, perhaps more efficient allocation of capital means that more innovation resulted because of smarter investment. i doubt it.

Money, Whitney notes, is what motivates people to come to Wall Street. It's not a public service job, nor should it pay like one.

Simple way to solve this. It should pay like a public service job and, basically, so should all employment. Take ridiculous salaries out of the equation and you'll end up with only those people who do the job because they're good at it and have a passion for it. No more risking the livelihoods of millions just for the chance of a fast buck. There isn't a person on this planet who needs more than £100k a year to survive, let's make that the limit and see what happens. Utopian idealism? Maybe, but I'd rather try it and see it fail than stick with the useless system we have in place at the moment.

The essential question is how we got into a situation where an individual banker's self-interest, even his whole firm's self-interest, became dis-harmonized with that of the macroeconomy.

People tend to assume that this is a natural state of affairs. In fact it is not natural at all. The (undesigned) genius of the pricing system on a free market -- including such old-fashioned notions as the sanctity of contract and bankruptcy for people who can't pay their bills -- is that self-interests are harmonized, and errors are self-correcting fluctuations, not systemic problems of motive.

The present crisis, like all the prior ones, resulted not from some spontaneous glut of private credit. Not a single rational proposal has been made for how this could have happened. The real cause is clear. Greenspan & Co. jammed interest rates down to ridiculous levels after the dot-com bust and held them there. Supply-side economists cheered this on all the way, which only demonstrates that while they pretend to be free market advocates, they know little about the single most massive aspect of government control in our mixed eocnomy: the Federal Reserve's insitutional price-control on credit.

Since we've socialized the downside, we need to socialize the upside

Everything depends on what you take as given. What we need to do is to stop socializing anything. Assymetric pay-offs have been taken. Sunk cost. That money is gone. It's time to start wondering what was the driver behind the existence of those risk-ramping, credit-fueled asymmetric pay-offs in the first place.

By Eric Dennis (not verified) on 05 Feb 2009 #permalink

James,

Your claim is not supported by the data. Average productivity in patents and research publications per scientist/engineer is correlated with ability level as measured by cognitive testing and shows no sign of leveling off even at the 1 in 10,000 level. Individuals at this level are far more likely to be found at top graduate and undergraduate programs than in other places. There is no oversupply of cognitive horsepower.

(1 in 10,000 in ability means the top 500 or fewer high school seniors each year -- easily absorbed by the top 10 universities. I would guess that at least half of this population each year ends up at an elite school.)

Horsepower matters

PS I agree with Razib here, although in the long run plumbing like derivatives, CDOs, etc. will be useful to society once we get the hang of using them, as we have with simpler bonds and insurance.

"i'm less concerned that the rich retards were dazzled by magic derivatives than that many super-geniuses were spending their 20s & 30s moving money as opposed to innovating.* the positive externalities of getting mucho-rich are way less than inventing a new technology which increases total societal productivity.

* yes, perhaps more efficient allocation of capital means that more innovation resulted because of smarter investment. i doubt it."